Goldman Sachs Enters Hall of Shame

By Inya Ivkovic, MA Published : April 21, 2010

By Inya Ivkovic, MA — The Financial World According to Inya column

Hard to miss this one: that is, the U.S. government going after The Goldman Sachs Group, Inc. (NYSE/GS) with all of the pomp and circumstance that it can muster. I’d love to be a fly on the wall in that boardroom where the Securities and Exchange Commission’s (SEC’s) damaging accusations are going to be discussed, such as the venerable institution on one hand promoting subprime mortgages to its clients and on the other helping a hedge fund take bets against both the products and those who bought them.

What is all the hoopla about? Back in 2007, just after partnering with a large hedge fund, Goldman Sachs was really into something called “synthetic collateralized debt obligations,” or the infamous CDOs. CDOs are essentially derivatives, but they also have some features of bond mutual funds. The CDO is a derivative because its value is derived from an underlying obligation, which, in the case of a subprime mortgage, is a debt obligation. Because the underlying debt obligations are all bunched together (synthesized), the CDO also resembles a bond mutual fund.Things would have been very different had the “smartest guys in the room,” such as those who were performing the new product due diligence at Goldman Sachs, done their homework and investigated the quality of the underlying. Sadly, they only looked into creditworthiness of those who had packaged and sold the CDOs. As long as things were hunky-dory on that end, Goldman Sachs had no qualms peddling such high-risk speculative investments to its clients under the guise of triple-A ratings of issuers that also offered attractive coupon payments.No one seemed to care what rotted underneath the shiny the surface, with only a very few notable exceptions. Such an exception, albeit a devious one, was Paulson and Company, which, lo and behold, is a hedge fund. As it turned out, the fund had little faith in the housing market and wanted to bet against it. Only, there was nothing yet worth making the bet against on the market. That is where Goldman Sachs’ product-engineering machinery came in, divining the CDOs and ways to play both sides of the market. At least, at this stage, this is how the SEC has dissected the events that had led to Goldman Sachs’ current fraud charges.According to the SEC, it was Goldman Sachs, in cooperation with Paulson, that created a mutual fund plush with mortgages of the worst kind, focusing on areas where Paulson had identified serious weaknesses, such as Florida, Arizona, Nevada and California, where
the most mortgages appear to have been given to people with the worst credit scores in the country.Additionally, Goldman and Paulson focused on mortgages with adjustable rates, which were the first to suffer if interest rates were to go up—which was an inevitability. In other words, the SEC alleges that Goldman and Paulson purposely built a fund that was designed to fail so that they could first get the suckers in and then bet against both the fund and everyone who was invested in it.

It seemed like a flawless plan, but the SEC begs to differ. When Goldman and Paulson designed the fund, they needed to sell it to someone first. That was where the whole thing went wrong. In order to sell the fund to investors, Goldman and Paulson would have been
crazy to admit that the fund was full of junk and that they planned to keep it afloat only for as long as the market held. Of course, they said nothing to their investors, breaking who knows how many securities laws in the process (allegedly), and started touting the fund to large institutional clients.

The rest of the story is a familiar one. Paulson was right. The real-estate and subprime markets were ripe to implode, and the time was ripe for the worst recession in a generation to wreak havoc on the global economy. In the process, Paulson made $1.0 billion shorting its own fund, while the investors going long on the trade lost the same $1.0 billion.

One might say that this is not fraud, just your typical, everyday circus in the markets. After all, someone has to lose for someone else to win. That would be fine if Goldman and Paulson had not unleashed the mother of all conflicts of interest on unsuspecting investors and sought to profit from it, too (again, allegedly).

What do I think of it? I think that Goldman and Paulson are as guilty of fraud as any common criminal is. What evidence the SEC has remains to be seen, but it has to be good, considering the fanfare with which the agency went after Goldman. Additionally, if the prosecution of Goldman ends up the way I think it will, there will likely be plenty more where this one rotten apple came from. I just fear that we will learn yet nothing again, until the next crisis hits, which would only then seem like an apropos time to dust the history
books off and analyze the events of the past to death while aimlessly trying to divine the future.